Italy compromise paves way for temporary government

Further polarisation of Italian politics looks in store, with steep uncertainties for financial markets, as the result of the extraordinary weekend re-election of 87-year-old President Giorgio Napolitano, likely to speed-up formation of a new government.

The weekend machinations in Rome will lower short-term uncertainty two months after Italy’s inconclusive elections in February. But this will be at the expense of longer-term worries over Italian stability at a time when – despite the country’s tough austerity measures – public debt is rising this year to 130% of GDP.

In Germany, where Chancellor Angela Merkel is taking a noticeably harder line on euro rescue measures, public debt is starting to fall from an expected peak of just over 80% of GDP this year. The Berlin government is stepping up a Europe-wide drumbeat in favour of further savings in public spending and fresh efforts to bring debt down towards the euro area target of 60% of GDP, at present widely missed by nearly everyone.

A new government in Italy is expected to be formed very soon, backed by supporters of both mainstream parties who did well in the February elections: the left-wing Democrats of Pier Luigi Bersani (who resigned at the weekend) and the right-wing People of Liberty party of former prime minister Silvio Berlusconi. Among those tipped as possible prime ministers are former incumbent Giuliano Amato (in office in 1992-93 and 2000-01), Enrico Letta, a top Democrat official, or a leading member of the Bank of Italy.

Few shocks can be expected in the Italian economy in the next few weeks, since legislation laid down by the government of Mario Monti, still in office as caretaker, means that the country is on a form of economic autopilot. However, the weekend association of the two parties of left and right to re-elect the elderly Napolitano, following the rejection of repeated attempts to find a new presidential figure, sets longer-term alarm bells ringing for three reasons.

First, any suggestion that Berlusconi or his friends are on the verge of returning to power would be highly destabilising. The former prime minister is not on speaking terms with Merkel after launching abusive comments about her following his departure from office in 2011. He has taken an increasing anti-euro line following the celebrated ultimatum against his policies by the European Central Bank and Bank of Italy in August 2011.

Second, the Democratic party is now in disarray following Bersani’s resignation, a reaction to his repeated failure to rally his troops behind a presidential alternative to Napolitano. Earlier, Bersani was seen as Italy’s best chance for stability following Monti’s eventual departure.

Third, over the weekend Beppe Grillo, leader of the anti-establishment Five Star Movement, condemned as a sell-out the behind-the-scenes deal to re-elect the patriarchal figure of Napolitano. He has called upon his supporters to protest in the streets. Grillo’s movement won 25% of the votes in February, far more than expected. His grouping can be expected to pick up more protest votes if the new government fails to make much headway in coming months.

Left and right-wing radical parties may be expected to gain influence as Italy heads for another election, probably in late autumn, after the new government completes institutional reform measures. Bond markets may remain reasonably placid for a while. But we may face a summer calm before an autumn storm.